June 29, 2020
By Paul Bubny
Even amid the uncertainty resulting from the COVID-19 pandemic and the surrounding downturn, both lenders and borrowers are actively in the market. However, their priorities and their methods of operation have shifted compared to the outset of 2020. We asked Walker & Dunlop’s Mark Strauss and Rob Quarton, managing director | capital markets and director | capital markets, respectively, for insights into what they’ve been seeing.
Q: Refinancing existing properties appears to be the most attractive course of action for many owners at present. Along with locking in currently low interest rates, what are some other strategic objectives for doing a refi at this time, compared to putting a property up for sale?
A: In addition to the historically low rates, our clients have seen significant value in the ability to convert loans to full term or partial interest only at this time. For some owners and operators, better net cash flow after debt service is a priority, and for some, return of equity from debt refinance is valuable. With a long-term hold strategy, refinancing helps them hold onto great assets at a low cost of debt. Further, refinancing generates a tax-free cash flow distribution to the borrower. In this case, excess proceeds from refinancing can be reinvested in any asset class over any time period without being subject to the pressure of 1031 exchanges or Opportunity Zone time frames.
Q: Talk about the current environment for construction financing. In the multifamily space at least, is financing as available as it was pre-pandemic, and at comparable LTV levels?
A: Generally, we’ve been seeing that lenders are not as aggressive compared to Q1 2020 pre-COVID levels. They are offering lower LTC and LTV leverage. Pricing has gone up too, given the increase perceived market risk. On the bank side, national players are staying on the sidelines, but regional banks are picking up on lending and capacity. Our experience with debt funds and mortgage REITs is that they’ve also pulled back. The appetite does vary depending on the asset being financed. Some construction to permanent financing activity is taking place in the multifamily and industrial space, which is appealing to life company lenders.
Overall, we’re seeing about 40% or fewer lenders in the fund space. Land, labor, and material costs are all getting more budget review scrutiny as well as a more thorough downside evaluation for a less optimistic lease-up schedule and rental growth projections.
Q: What stipulations are lenders making at present, and do you believe they’ll be in place for the next few quarters?
A: Most often, lenders are paying close attention to including reserve holdbacks for debt service, operating expenses, or taxes and insurance at closing. They are structuring these reserve escrows to cover between six to 12 months, unless the transaction is low leverage. Lenders are also stressing the need to understand the real estate owned schedule and if owners are experiencing any distress from other assets. Hard Lock boxes for retail, hotel, and potentially office will be put into place, as well as increased TI/LC reserves estimates on future roll. Pre-COVID, lenders were competing by reducing covenant restrictions, but that – of course – has reversed.
Q: Especially for development projects, are we seeing sponsors turning more to joint-venture equity structures now?
A: Preferred equity with a higher GP equity contribution is currently the most viable strategy to attract equity partners right now. Also, potentially structuring a deal closing in Q4 2020 or Q1 2021 would allow more time for economic recovery to take place and provide more certainty on the viability of a given property’s business plan. However, in select cases, equity funds are willing to closer sooner for opportunistic buys or below market trades. Equity investors are requiring higher preferred returns but also increasing promotes on back-end to make the sponsor prove up the property performance. Equity generally wants higher expected returns on the deal level. For example, pre-COVID, deal-level levered IRRs for value-add apartments were 12-15%. Nowadays, it at least needs to be 15% or higher for primary and strong growth secondary.
Apartments remain the favored asset class, especially single-family-for-rent developments. Developers have seen some of their traditional LP partners pause in the market, which has motivated them to seek additional – or new – equity partners. To find that new partner, the search requires talking to many more prospective equity partners, which draws out the timeline.
Q: Following up on the last question, any particular markets or product type that are more favorable to investors right now? Performing better in the COVID-19 environment?
A: Single-family resi for rent is a very bullish concept right now. This sector is being fueled by older millennials preferring to rent versus buy, along with the desire for larger units (three bedrooms or greater). For these assets, the targeted return thresholds are 15% levered IRR and 6% Return-On-Cost.
Additionally, the preferred design type is for larger homes with more traditional home design (three bedrooms, 1,500 square feet or bigger.), instead of horizontal, small, garden-style properties (1-2 bedrooms, 750 square feet). Another appealing feature of the asset classes is the ability to refinance with agency debt from Fannie Mae and Freddie Mac. This gives the developer the valuable optionality to refinance with long term debt or sell depending on market conditions.
Q: Acquisition volume appears to be down at the moment as transactions that went into contract pre-COVID are coming through the pipeline. How does this compare to acquisition financing—would it be readily available if buyers were looking to transact?
A: Acquisition financing is definitely available right now. Bridge debt offers lower LTC (65%-70%) and pricing is up (Libor + 4.00 to 500%). There are outliers to this guidance, but the outreach will have to be expanded significantly to find the best terms or recourse options. There is considerable liquidity in long term fixed rate debt for stabilized product, like multifamily and industrial. Office, on the other hand, is seeing more debt availability for stronger markets, multi-tenant, national vs. local tenants, and safe building operation protocols to combat COVID. Other product types (hotel, retail, land, etc.) have proven to be more difficult.
Finally, there are probably 40% fewer bridge loan lenders in the market today versus 90 days ago that will lend on value-add acquisitions. Those that have remained active and competitive have been able to lend off their own balance sheet and have not had to rely on repo lines or CDO executions to maintain liquidity to lend.
Deals that had been finding a home with marginal sponsors, transactions with rent assumptions leading the market, or contained aggressive lease up time frames, are not currently getting done. Those remaining in the market have been making loans “selectively” based on prior relationships or disciplined underwriting. Lenders have commented that pricing and leverage is now more in line with perceived risk of the business plan and asset. Leverage has reduced 5%-10% and pricing has expanded 0.50%-1.50%.
Pictured (at left): Mark Strauss. (At right) Rob Quarton.
For comments, questions or concerns, please contact Paul Bubny